If Saudis pump more oil, will gasoline prices fall?

ByDavid R. FrancisJune 3, 2004

Before the invasion of Iraq, former Saudi oil minister Ahmed Zaki Yamani warned the United States it was "playing with fire."

So it has proved - not just politically but economically as well.

Continuing uncertainty over Iraq pushed oil prices above $40 a barrel on May 11 for the first time since 1990. Though crude dipped below $40 late last week, economists say the price spike, if continued, will be a drag on the US and world economies. Nine of the 10 post-World War II recessions in the US were preceded by sharply rising oil prices.

In a key meeting Thursday in Beirut, OPEC (Organization of Petroleum Exporting Countries) will discuss a Saudi plan to boost its output to maximum capacity. The goal: to drive down the price of oil - and thereby eventually ease the price crunch on the world's drivers.

Most OPEC nations are running at full capacity already. Kuwait and the United Arab Emirates may have a little excess capacity. But only the Saudis have sizable excess capacity - not to mention the world's largest proven oil reserves.

Last weekend's terrorist attack on an upscale housing compound in Khobar - the heart of the kingdom's oil industry - has further raised concerns that the Saudis may be unable to protect their oil facilities. When oil trading resumed Tuesday, its price surged back above $40 per barrel.

Saudi Arabia pumped 8.3 million barrels per day (b.p.d.) in April, above its OPEC quota of 7.64 million. Saudi officials say they are raising output to 9.1 million b.p.d. to meet rising world demand and hope to boost their nation's capacity to 11.3 million b.p.d. by fall.

Although terrorists may wish to disrupt that production, the Saudis maintain that their oil fields are well protected against attack.

World demand, surging above forecasts, could soak up extra Saudi production and leave prices at a high level. Oil prices per barrel are likely to stay in the $30s and "at times possibly into the $40s" for one to two years, forecasts Cambridge Energy Research Associates.

When Sheikh Yamani was the leading figure in the oil producers' cartel, during the energy crises of the 1970s, OPEC was often viewed as a knavish group - quadrupling oil's price unjustly at the expense of consumers.

"Today, nobody thinks of OPEC as a villain," says John Lichtblau, a veteran oil economist at the Petroleum Industry Research Foundation in New York. No one in a responsible position in Washington or in European capitals condemns it. "The emphasis is on collaboration and consultation," he says.

Why? Because governments crave stability in energy prices. And OPEC has become a welcome though imperfect regulator of world oil prices. By turning the spigot on and off, the cartel tries to manipulate prices.

For example: In 1986 George H. W. Bush, then vice president, asked Saudi Arabia to raise the price of oil, according to Yamani. At the time, low prices were devastating oil-producing areas in the US, such as Texas.

Even in the oil business, few want a truly free market. They prefer price stability, rather than the volatile prices associated with unmanaged output of a commodity. Major OPEC producers don't want a price so high it encourages non-OPEC production and real conservation.

The problem today is that OPEC is "not very efficient," says Fadhil Chalabi, executive director of the Centre for Global Energy Studies, a think tank in London created by Yamani. "OPEC should improve its skills of managing supply." (Dr. Chalabi comes from Iraq, but from a different branch of the Chalabi family from Ahmad Chalabi, the Pentagon's former favorite to lead a free Iraqi government.)

OPEC had indicated a goal of keeping the price of oil in a range of $22 to $28 a barrel. It even planned a cut in production quotas at the end of March. But, complains Chalabi, when the demand for oil in booming China and the US skyrocketed, OPEC did not abide by its own strategy, failing to raise output.

Now $28 is seen as a floor.

OPEC members are too much influenced by their short-term need to maximize revenue, rather than their long-term interest in maintaining the world market for oil, he says.

Further roiling the oil markets is the uncertainty over Iraq and Saudi Arabia. Though Iraq probably has the world's largest reserves after Saudi Arabia (excluding Canada's oil sands), sabotage knocked its oil output last month to about 1.8 million b.p.d. Production could be restored to 2 million b.p.d. this month - and perhaps 3 million b.p.d. by year's end, if all goes well.

"The real fear of the market is that if anything happens to Iraqi oil, there is no extra capacity in the world to compensate," Chalabi says.

Such a scenario could damage the US and world economic recovery.

Since the end of 2001, gasoline prices have risen about 90 cents a gallon in the US, notes Irwin Kellner, an economist at Hofstra University in Hempstead, N.Y. That takes $90 billion out of the economy, money not available for other purchases of goods and services since most of it goes for oil imports rather than to a shrinking number of domestic producers.

It is a drag equivalent to 28.5 percent of the $316 billion in stimulus provided by the three Bush federal tax cuts in fiscal years 2001 through '03, Dr. Kellner notes. The hike in energy prices, he adds, raises the risk of "stagflation" - the combination of more inflation and slow growth that plagued the 1980s.

Some analysts are not so gloomy. For instance, Michael Lynch, president of Strategic Energy & Economic Research in Winchester, Mass., suspects that US gasoline prices will drop after July, with extra Saudi production arriving on the East Coast, holiday driving diminishing, and conservation (car pooling, etc.) having a modest impact.

Ironically, the last time oil surged above $40 a barrel, Iraq had just invaded Kuwait in 1990. By removing Saddam Hussein, the current President Bush hoped to create more political and economic stability in the Middle East.

So far, though, the invasion has created uncertainty and higher oil prices. Whether that will hurt President Bush's prospects for reelection is debatable.